If you’re thinking about or researching how to invest your money, you’ve likely run into two different investment vehicles, ETFs and mutual funds, that have overlapping characteristics. Well-known personal finance guru Dave Ramsey says a 12% average return from a well selected mutual fund is a reality, while investor demand for ETFs has quadrupled since 2002. So which investment tool is best for you? And what’s the difference between an ETF and a mutual fund, anyway?
What is a mutual fund?
Mutual funds are pooled investments. Typically, with an interest in diversification, a fund manager selects stocks, bonds and other investment vehicles that they believe will successfully meet the investment goal of the fund. When you purchase shares of a mutual fund, you own a portion of all items in the fund. Mutual funds are actively managed, meaning a fund manager or committee chooses when to buy, sell and change allocations of the assets in the fund as they see fit. Mutual funds can be purchased through a broker, online or in person.
- Pros: Typically offer diversification, usually within one asset class like large cap stocks, although some funds hold more than one asset class like stocks and bonds. In most cases the investor can set up automated contributions without paying additional transaction fees. Mutual funds require minimal investor knowledge, since the fund is managed by a professional.
- Cons: High management fees due to active management. Sometimes commissions are paid on top of management fees to purchase mutual funds. Potentially higher tax consequences due to active trading within the fund. Can only be purchased or sold at the fund’s net asset value (NAV) established at the end of the trading day. Normally a minimum investment amount is required.
What is an ETF?
ETFs, or Exchange Traded Funds, are also pooled investments chosen by a fund manager. Typically, ETFs are diversified throughout one asset class such as real estate or domestic equity, although more and more blended (multiple asset classes) ETFs are becoming available. Another distinction of the ETF is that the fund manager selects the allocations of the fund, but does not actively trade the holdings. This passive investment approach (think buy and hold) translates to lower management fees than mutual funds. Also, as the name implies, ETFs trade on exchanges and can be bought and sold intraday like a stock.
- Pros: ETFs offer diversification within an asset class, low management fees due to passive management and most ETFs are commission-free. They trade like a stock and are excellent buy and hold options. There is no minimum investment requirement and ETFs have lower tax consequences due to lack of internal fund trading.
- Cons: May need more than one ETF in your portfolio to fully diversify. If not purchased to buy and hold, the investor inherits the burden of trading and every buy and sell of an ETF collects a small trade fee. There is no automatic investment option like a mutual fund.
What type of investor chooses mutual funds over ETFs?
The hands-off investor looking for some degree of diversification who doesn’t mind paying higher management costs and/or commissions in exchange for the peace of mind of knowing his investment is being watched over by financial professionals.
What type of investor chooses ETFs over mutual funds?
The buy and hold investor who is slightly more hands on and believes that in the long run the money saved from lower management fees outweighs the potential value add of active fund management.
Every investor’s situation is different and there is no one size fits all financial advice. If you’d like to discuss your financial situation and learn how to invest your money in detail contact us at getstarted@arkfi.com
Photo by Scott Beale
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